If you have a traditional pension plan, your employer makes all the investment decisions for you. With most of the other retirement plans discussed in this chapter, you're in the driver's seat. Some people find that intimidating, but it doesn't have to be. If you've read Chapter 17, you have a basic understanding of the investment options that are probably available in your retirement plan: stocks, bonds, mutual funds, cash equivalents, and maybe your employers' stock. Putting all your funds in one type of investment increases your risk of loss if that investment doesn't perform well, so spread your funds out over several types of investments.

Stocks, Bonds, and Mutual Funds

With retirement investing, it's important to think long term. Because retirement earnings grow tax-deferred and you have many years before you'll make withdrawals, retirement plans are best suited for your most aggressive investing, which means stocks and mutual funds. Don't make the mistake of putting all your money in money market funds or guaranteed investment contracts (GICS) unless you have a good reason to do so (for instance, if you know you're going to cash out and spend the money within a few years). Diversify your portfolio to balance risk and reward and you should come out far ahead in the long term. This doesn't mean you shouldn't choose your investments carefully. If 80 percent of your retirement funds are in stock mutual funds, most of it should be in well-established funds with a history of solid performance. If you want to get aggressive with some of your money, you can place a small percentage of your stock investments in higher-risk funds.

Lifestyle, Lifecycle, and Asset Allocation Funds

Most retirement accounts these days offer a prepackaged option so that you don't have to select investments and build your own portfolio. Instead, you use a model portfolio designed by an investment company. For most people, this is the way to go. If you don't have the time, energy, desire, or expertise to create your own portfolio, you can let an expert do it for you.

These portfolios are generally diversified among large, medium, and small companies within the U.S. and abroad. In addition, they'll have corporate, government, and high yield bonds, along with some cash. In this way, you get a diversified portfolio by choosing just one investment option.

In addition to diversification, many of these programs adjust themselves for you over time. So-called “lifestyle” or “lifecycle” funds use a target date to determine how much risk the portfolio should have. For example, you might have the “XYZ 2040 Fund” as an investment option in your retirement plan. The “2040” refers to the year 2040. This fund might be used by a person planning to retire in 2040 (in other words, the year 2040 is the target date for the fund). Perhaps this is a person born in 1975, so she'll be 65 years old in 2040.

These funds are managed based on the amount of time until the target date. If the year is 2010, the managers of the XYZ 2040 Fund will most likely have a high percentage of assets in stocks. As the years pass, the fund's managers will gradually reduce risk by adding bonds and cash. The investor (you) does not have to spend time and energy making these adjustments.

ESOPs

Chapter 9 briefly mentioned ESOPs, which give you an opportunity to own stock in the company that employs you. These plans can be a great benefit, but there's one very important caveat: don't put all your eggs in one basket. Thousands of employees who did so have lost their entire retirement funds when their employer's stock lost value due to corruption or shaky accounting practices that hid serious financial problems. If company stock is the only option available to you in your 401(k) plan, look at other investment vehicles for some of your retirement savings.

Consider a worst-case scenario for people who invest heavily in company stock. If something bad happens to the company, it's likely that the stock price will fall. In addition, your job could be in jeopardy — if there are layoffs or if the working environment becomes unbearable. In this case you suffer a double whammy: your retirement savings take a hit at the same time as your income.

Annuities

Annuities are insurance contracts. They allow you to deposit money into the contract, and either take income immediately or leave the money invested. Your grandparents may have used annuities to buy themselves a guaranteed income stream in retirement (or their employer did this to provide a pension). At your age, you would most likely put money into an annuity and leave it there.

Annuities may be fixed or variable. Fixed annuities credit your account at a fixed rate agreed to by the insurance company. Variable annuities invest your money in the financial markets, very much like mutual funds. In addition to investment options, annuities can offer a dizzying array of bells and whistles called “riders.” A rider may guarantee to refund your money after ten years if you lose it in the markets, or it may offer an enhanced death benefit to your beneficiaries if you die.

Your earnings grow tax-deferred, but the money you put in is not tax-deductible, so this is an investment best suited to someone who has already taken full advantage of all the tax-deductible plans available and still has money left over to invest. It's unlikely that the average person in her or his twenties or thirties would choose this investment vehicle, but you should be aware of it in case an insurance agent attempts to sell you one.

Belt and Suspenders

Annuities are useful in some situations, but they are prone to abuse. They are terribly difficult to understand, even for professionals. As a consumer, you'll find that the fees and expenses are difficult to identify and understand. All annuities have a cost, and you have to pay extra for any riders. In many cases, you have to leave your money with the insurance company for years before you can do anything else with it. Therefore, be very careful when buying an annuity.

Be especially careful about putting retirement savings into an annuity. Don't roll a 401(k) or IRA into an annuity unless you have a very good reason. At your age, the most likely benefit you can get from an annuity is tax-deferral. Retirement accounts already benefit from tax-deferral, so annuities must offer you an additional benefit if you're going to pay the costs associated with them. Putting retirement savings into an annuity for the purpose of tax-deferral is like wearing a belt and suspenders at the same time to keep your pants up.